The Post-Keynesian View on Exchange Rates: towards the consolidation of the

different contributions in the ABM and SFC frameworks1

Raquel Ramos2 and Daniela Magalhães Prates3

Resumo: O artigo contribui para a consolidação da visao pós-Keynesiana sobre

taxas de câmbio nominais de duas formas complementares. Em primeiro lugar, ele
apresenta uma análise dos dois grupos de trabalhos pós-Keynesianos sobre o tema,
dividindo-os em dois grupos: um enfatisa o papel das análises técnicas, da convenção
financeira e dos behavioural insights na tomada de decisão dos investidores de mercados
de câmbio em países avançados, enquanto o outro é focado nas dinâmicas das moedas de
economias emergentes, analizando como a posição de uma moeda nos sistemas monetário
e financeiro internacionais influencia a decisão dos money managers. Em segundo lugar,
o artigo sugere o uso de equações de modelos baseados em agentes (AB) e de coerência
de fluxos e estoques (SFC) como forma de consolidação dos principais argumentos dessa
literatura em um arcabouço único. A flexibilidade oferecida pelo arcabouço AB-SFC
possibilita uma análise complexa, detalhada e realística sobre a formação de expectativas
em mercados de câmbio e alocação internacional de portfolio, avançando no debate
teórico e aperfeiçoando modelos pós-Keynesianos formais.

Abstract: The article contributes to the consolidation of the post-Keynesian (PK)

view on nominal exchange rates on two interconnected steps. Firstly, it presents a critical
assessment of the different PK works on this issue, dividing them into two strands: one
highlights the role of technical analyses, financial convention and behavioural insights in
investors’ decision-making process in advanced countries’ FX markets, while the other
focuses on the dynamics of emerging market economies’ (EME) currencies, analysing
how a currency’s position in the current International Monetary and Financial System
(IMFS) influences money managers’ decisions. Secondly, the article suggests the use of
the agent-based (AB) and stock-flow consistent (SFC) equations for consolidating the
main PK arguments in a common framework. The flexibility of the AB-SFC framework
allows for a complex, detailed and realistic account of expectations formation in FX
markets and international portfolio allocation, enhancing the theoretical debate and
formal PK models.

JEL codes: B5, F31, F37.

Keywords: Exchange rates, Currency hierarchy, Agent-based modelling, Stock-

flow consistent modelling.

Área de submissão: macroeconomia aberta

1
Paper to be presented at the 11th meting of the Brazilian Keynesian Association (AKB),
entitled “Desafios para a economia brasileira: uma perspectiva keynesiana”. To be held in Porto
Alegre, Brazil, 15th -17th August 2018.
2
Postdoctoral researcher at Universidade Estadual de Campinas. Contact:
raquelalmeidaramos@yahoo.com.br.
3
Professor at Universidade Estadual de Campinas.

1
 1 Introduction

The behaviour of nominal exchange rates has long been a puzzle in mainstream
economics1. Unsurprisingly, the interest on this key issue has flourished in two periods
featured by the predominance of floating exchange rates - the first years of the interwar
period and after the collapse of the post-Bretton Woods regime - when the research on its
determinants has become theoretically relevant (Macdonald 2007). In the case of the post-
Keynesian (PK) approach2, focus of this paper, exchange rates started to drawn attention
of some scholars in the early 1980’s following the high instability of the new International
Monetary and Financial System (IMFS).

The different PK contributions share a view of exchange rates in this historical

setting as a result from bank dealers’ and, mainly, money managers’ portfolio decisions,
predominantly, institutional investors, whose increasing importance is a major feature of
the current phase of capitalism (Minsky 1986, Bonizzi 2017a). These decisions, in turn,
are based on social conventions due to fundamental uncertainty. Some of authors also call
attention to the differences in exchange rate dynamics according to the level of
sophistication of foreign exchange (FX) markets and/or to the position of the currency in
the IMFS. While advanced countries’ exchange rates would present a zigzag pattern,
Emerging-Market Economies (EME) ones would face cycles of continuous appreciation
trends interrupted by sudden depreciations. These cycles would be associated with
different balance-sheet constraints of these investors that derive, in turn, from specificities
of EME currencies. Moreover, the PK approach on exchange rate are in line with what
Lavoie (2014) calls the school’s pressupositions, such as realism, historical and
irreversible time, and the importance of institutions.

Yet, the PK contributions on such crucial topic on open macroeconomics has been
rather disperse and, maybe because of that, has received relatively small attention of PK
scholars. For instance, Lavoie (2014) does not include the nominal exchange rate as one
of the school’s main themes. A consolidation of these contributions in what we could call
the PK view on the nominal exchange rate has not been drawn up yet and could contribute
for the dissemination of the school’s contributions.

This article contributes to fill this gap in the PK literature in two interconected
steps. Firstly, we present a critical assessment of the different PK works on this issue,
which highlight the role of technical analyses, financial convention and behavioural
insights in the decision-making process in advanced countries FX markets (section Two),
and the dynamics of EME currencies linked to their position in the current IMFS that
influences money managers’decisions (section Three)3. Secondly, in section Four, we
suggest the use of the agent-based (AB) and stock-flow consistent (SFC) equations for
consolidating the main PK arguments in a common framework useful for theoretical and
empirical analysis of exchange rates. The flexibility of the AB-SFC framework allows to
consolidate and to provide a more complex, detailed and realistic account of expectations
formation in FX markets and international portfolio allocation. As it will be seen,
although expectations and the concept of fundamental uncertainty are at the core of PK
analysis in general, up to now their treatment in formal PK models has been incipient,
making use of many simplifications. Section Five presents concluding remarks.

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 2. Decision making in the foreign exchange market: technical analyses, behaviour
insights and financial convention

The PK approach has a valuable contribution to the understanding of the dynamics

of exchange rates in the international financial and monetary system (IMFS) that emerged
after the collapse of the Bretton Woods regime. Important contributions to this
understanding are the works of Schulmeister (1987, 1988, 2008, 2009, 2009b) and Harvey
(1991, 1998, 1999, 2009) that have in common the aim at explaining the actual decision-
making process in FX markets, which underlies the high volatility of exchange rates in
this environment. Hence, coherently with the PK approach, both works search for
realisticness in their assessments (Lavoie 2014), and provide important insights on the
behaviour of technical (Schulmeister) and fundamentalist (Harvey) traders.

Schulmeister has analysed the pattern of exchange rate movements from a both
inductive and microstructure approach since the 1980s (Schulmeister 2009) stressing that
exchange rates do not follow a random walk (as inferred from Meese and Rogoff 1983),
but a systematic pattern that stems from the increasingly important technical trading
systems in the foreign exchange (FX) market (spot and derivatives), whose weight in
markets is demonstrated by survey studies (Schulmeister 2007, 2008). Exchange rate
dynamics would result from the interaction of different strategies and models used by
“chartist traders” (who decide to buy or sell based solely on the information contained in
past prices). Some of these models are trend followers, producing buy (sell) signals when
prices are rising (falling), while others are contrarians, producing buy (sell) signals when
prices are falling (rising) at a declining rate. Models are also differentiated according to
the speed of response to changes in prices: based on high frequency data, “fast models”
act before the “slow models” that are based on hourly or daily data.

According to Schulmeister (2008), such interaction starts after economic or

political news set off the trend as traders believe these will cause others to open a new
position in the market. Moreover, a trend gets a higher recognition and reaction if the
news is in line with the prevailing “market mood” (‘bullish” or “bearish” bias in
expectations that concern only the direction – appreciation or depreciation, not including
the expected total impact). Hence, it is possible to interpret this process as the keynesian
beauty contest, i.e., the trend is triggered and boosted by the market’s convention.
Conversely, the trend could end if an increasing number of traders open a position
speculating on the reversal of the trend, in other words, if they follow a speculative/non-
conventional behaviour. Two other factors could also contribute to the end of the trend:
the decline in the number of traders getting into the bandwagon (in a herd behaviour) and
the higher incentive for cashing-in profits.

Harvey (2009) consolidates his previous works and builds on Schulmeister’s

analyses of decision making in currency markets. Yet, Harvey (2009) also focuses,
specially on his “mental model’, on the behaviour of agents called “fundamentalist
traders” who consider the changes in macroeconomic variables in forming their exchange
rate expectations. His analysis of expectation formation includes, besides Keynesian
insights, concepts of behavioural economics that are used to explain the forecast-
construction biases in the FX market, which result in the features of the FX market
stressed by Schulmeister (2009), e.g., volatility, bandwagons and periodic profit taking
(cash-in).

3
 Harvey (2009) stresses that, given fundamental uncertainty, confidence is usually
at low levels in asset markets, resulting in forecasts that change rapidly and the need to
make quick returns; yet, due to animal spirits, agents are able to act despite their
ignorance; and the more confident the participant is, the stronger his/her response to an
economic change. Apart from these Keynesian insights, in Harvey’s approach heuristics
and biases emphazised by behavioural economics also contribute to the forecast-
construction biases of agents in the exchange rate market. According to the availability
principle, the more available an event is in our memory, the more frequent it is deemed
to be, resulting in a forecast bias, as agents overrate the importance of dramatic events.
The representativeness principle is related to the calculation of the probability that event
A is a result of event B: The more A resembles B, the more people will look for a causal
relation between the two. As a result, people constantly look for explanations about
exchange rate movements. With the anchoring principle, people make new forecasts
having a prior one as reference, putting undue weight on their first forecast, regardless of
how it was done.

Harvey’s (2009) “agents’ mental model’, shows how these forecast-construction

biases come into play when agents form expectations. This model is based in three layers:
(i) foreign currency demand depends on net exports, net direct foreign investments, and
net portfolio foreign investment; (ii) these are influenced by the expected inflation
differential between the domestic and the foreign country, the expected relative
macroeconomic growth, the expected relative interest rates, and the expected liquidity
(the “base factors’); and (iii) agents keep track of a list of indicators in building
expectations concerning changes in these factors (e.g., as GDP growth is not published
often, investors use unemployment rates as proxy).

In his “augmented mental model’, in turn, Harvey (2009) introduces exchange rate
determination from portfolio investment (that depends on exchange rate forecasts) and
the workings of five “exchange-rate features” highlighted by Schulmeister (2009):
volatility, bandwagons, technical analysis, trading limits and cash-in.

It should be noted that, although some of the base factors correspond to

“fundamentals” in mainstream models, in Harvey’s approach “fundamentals” affect the
exchange rate dynamic through their influence on agents’ expectations. In other words,
traders consider that there is a group of variables that may have an impact on the exchange
rate and trade accordingly – making these variables have an effective impact on the
exchange rate4, what is different than the mainstream idea that fundamentals directly drive
exchange rates to an equilibrium value (Harvey 2001).

Indeed, Harvey’s (2009) mental model could be seen as an example of what

Orléan (1999) calls “the financial convention’5 in his auto-referential approach, i.e., the
socially accepted, prevailing quantitative model used to estimate the expected value. In
this approach, instead of yielding in an objective and unique value for the asset,
fundamentals result in a subjective value, that depends on the workings of the group itself
(Orléan 1999). This is clear in Harvey’s (2009) argument that “the foci of expectations
formation will emerge as a function of the social context in which the agents interpret
their experiences and scholars and professionals engage in research” (Harvey 2009, 54).

The contributions of Harvey and Schulmeister led to the description of a detailed

and complex dynamics of exchange rates in the current IMFS, bringing to light the

4
different factors underlying the decision making process in FX markets, among which the
influence of technical analysis, the current financial convention, the Keynesian concepts
and heuristics in agent’s expectations and trading. Yet, Schulmeister and Harvey’s works
have some shortcomings as they disregard key features of the current IMFS. Firstly, they
only contemplate the financial side of exchange rate determination: they consider that
FDI and trade flows also have an influence on traders’ decisions, but do not include those
in the determination of exchange rates6. These models therefore do not consider the
feedbacks from the exchange rate to the economy and vice-versa, being a view of the
exchange rate determination disconnected from the economy as a whole. Secondly, they
do not account for external debt dynamics, i.e., financial flows linked to international debt
that still have a crucial role in capital flow cycles and, then, exchange rate movements.
Last but not least, as their analyses focus on the developed or advanced economies’
currencies, they cannot explain the specificities of exchange rates of emerging-market
economies (EMEs), defined as the developing economies that have engaged in the
financial globalization setting (the interpenetration of national monetary and financial
markets and their integration in globalised markets; Chesnais 1996). This last gap has
been fulfilled by PK works analysed in the next section.

3. Currency hierarchy and the focus on investors’ balance-sheet constraints

Another strand of heterodox works aims at understanding the behaviour of

exchange rates of EMEs (emerging currencies)7. These agree with the works presented
above on the relevance of short term capital flows and investors’ expectations and
decisions (anchored in social conventions due to fundamental uncertainty) in driving
exchange rates, but decisions are conditioned by the currencies’ characteristics, most of
them deriving from the place it occupies on the hierarchical IMFS, i.e., on the so called
currency hierarchy.

It is worth mentioning that Harvey (2009) recognizes, implicitly, the hierarchy

dimension of this system as he includes the expected liquidity of the assets in the base
factors, which “increases if the currency in which the asset is denominated is one in which
many commodities are priced or if it is the de facto or de jure international reserve
currency (the dollar has benefited from both since World War Two’; Harvey 2009, 85).
Yet, he does not discuss the implications of that hierarchy on the exchange rate dynamics
nor the existence of asymmetries between central economies’ currencies other than the
U.S. dollar and emerging currencies.

As Keynes (1944) pointed out during the Bretton Woods debates, the currency
hierarchy has been a fundamental feature of the international monetary systems that have
succeeded since the sterling-gold standard: in each of them a national currency has
assumed the role of leading or key currency (Andrade and Prates 2013; Kaltenbrunner
2015). In the post-Bretton Woods system, featured by floating exchange rates and a high
degree of capital mobility due to financial globalization, the fiduciary and flexible U.S.
dollar, placed at the top of the currency hierarchy, has performed such role due to its
ability to perform the three functions of money internationally (medium of payment, unit
of account and denomination of contracts, and store of value). The currencies issued by
the other advanced countries are in an intermediate position as they are used as a means
of payment and of denomination of contracts internationally and its financial assets are
demanded as a store of value by foreign investors. At the bottom of the hierarchy are the
currencies issued by EMEs that are incapable of performing those functions, even

5
marginally (Andrade and Prates 2013). With the increasing importance of the euro as
store of value and unit of account, the IMS has arguably gained a fourth layer, where the
euro occupies the second-most central place (De Conti et al. 2014).

From the post-Keynesian perspective shared by these works, the currency

hierarchy has revealed itself even more deleterious to the EMEs, whose currencies are
positioned at its lower end, and the different positions in the IMS would steem from
different levels of liquidity premium: the one of the U.S. dollar being higher than that of
advanced currencies, which are higher than of emerging currencies. As the liquidity
premium is an attribute of assets in monetary economies, Keynes’ equation on an asset’s
total return (Keynes 1936) has been adapted to open economies to the analysis of
emerging currencies dynamics (Andrade and Prates 2013; Kaltenbrunner 2015).

With this equation, Keynes (1936) indicated that in a monetary production

economy an asset’s “total expected returns” (or “own interest rate’, r) is determined by
four main attributes: its expected appreciation (a), its quasi-rent (q, or yield), its carrying
costs (c) and its liquidity premium (l)8 – as in Equation (1). When applied to the different
currencies, r refers to the “total expected returns” of an asset denominated in a specific
currency, a to the expected appreciation/depreciation and q to the short term interest rate
of this currency, and c to the degree of financial openness of the issuer country; the lower
such degree, the higher the transaction cost to invest in such asset (Andrade and Prates
2013).

r = a + q−c + l (1)

While the different liquidity premiums express a monetary asymmetry, EMEs

have also faced a financial asymmetry in the current IMFS that is related to the different
magnitudes of capital flows to countries positioned at the different layers of the currency
hierarchy, those directed to EMEs being marginal in comparison to total flows (Andrade
and Prates 2013). Although marginal, these flows exercise important pressures on EME’
FX markets due to their small relative size. Haldane (2011, p.2) uses the “Big Fish Small
Content” metaphor to illustrate this issue: “The Big Fish here are the large capital
exporting, advanced countries. The Small Ponds are the relatively modest financial
markets of capital-importing emerging countries.” EMEs are therefore integrated to
international financial markets, but under different conditions than central economies,
with currencies that do not offer the same liquidity premium and being subject to more
relevant changes in their assets prices (and their currencies’) for their relative small size.

Money managers have their liabilities in advanced countries and assets allocated
throughout the globe, in advanced and EMEs, creating a network that connects these
markets through these institutions balance-sheets (Ramos 2017). As it will be argued in
what follows, the exchange rate dynamics put forward by Post-keynesian analyses can be
seen as consequence of institutional investors’ decisions based on their balance-sheet
constraints in a international context featured by monetary and financial asymmetries.

Concerning the asset’s side of the balance-sheet, the fact that EMEs’ assets are
not used as store of value make their currencies prone to sudden depreciation in moments
of high liquidity preference in international financial markets, when investors prefer to
keep their assets in the most liquid form (Andrade and Prates 2013, 402). This can be
represented as an increase in liquidity preference (β) in equation (2) – an adaptation of

6
the format proposed by Kaltenbrunner (2015), that is focused on emerging currency’s
total return relative to the key currency, whose attributes are represented by *). Given that
l∗ is (structurally) higher than l9, the liquidity premium differential (l −l∗) has a negative
effect on the relative return of the emerging currency (r −r∗), which is majored with an
increase of liquidity preference (β) decreasing the demand for the emerging currency10.

r−r∗ = (a−a∗) + (q−q∗)−(c−c∗) + β(l−l∗) (2)

If the impact of a hike of liquidity preference in the demand for emerging

currencies is quick, the fall of liquidity preference has a prolonged effect: not only its
decrease, but also its maintenance at a low level progressively increases investment in
EMEs. This phenomenon is explained by changes in investors’ perception about a market
in a Minskyan (1986) causality: as the memory of a crisis fades, investors that previously
decided not to invest in EMEs progressively reconsider this decision as excessively
conservative and change opinion, gradually increasing the total amount of investment in
this market (Author). An interesting point is the individualization of risk, that instead of
being a measurable value, depends on agent’s perception – as they varied, in Minsky’s
(1986) work, according to the famous three types of agents. This dynamic is also in line
with the availability principle (discussed in the previous section): right after a crisis,
investors will assess the probability of another exchange rate crisis as very high, not
investing in the concerned currency. This helps explaining the long waves of appreciation
faced by emerging currencies.

Emerging currencies’ demand also decreases in moments of capital flight or

currency crisis due to investors decisions based on their liabilities: in these moments
investors need the central currencies used to denominate liabilities in order to meet their
financial commitments. In Kaltenbrunner’s words (2015, 436), they need to convert assets
into “the currency with which positions in these assets have been funded”.

Besides these reasons related to investors’ assets (Andrade and Prates 2013) and
liabilities’ sides (Kaltenbrunner 2015), two other balance-sheet constraints explain
emerging currencies’ sudden depreciations. First, in moments of higher uncertainty
investors need to decrease the currency mismatch of their balance-sheets (caused by
having assets labelled in emerging currencies) eliminating this additional element of risk
(Author). Second, if the investor must cover losses in the country where it has its
liabilities, markets that are part of this investor’s portfolio will face a sell off and currency
depreciation, i.e., financial contagion (Ramos 2017). Then, we can conclude that
emerging currencies are subject to shocks in markets around the globe for being part of
money managers’ network also due to these balance-sheet constraints.

Finally, the cyclical pattern of emerging currencies might also emerge from the
influence of monetary conditions in central economies. Given that institutional investors
have target rates of returns, which determine the growth of their liabilities, they must
ensure that the return of their assets grow at the same rate as their liabilities’ costs (Bonizzi
2017a, 2017b). For instance, in case of lower interest rates among advanced countries,
where they have most of their assets, an option for achieving the needed growth of assets
is to invest in EMEs, whose returns are generally higher. In the short term, this constraint
leads to the appreciation of the EME currencies, yet followed by depreciation when
monetary policies become more restrictive in these countries.

7
 Hence, these analyses argue that the dynamics of low-liquidity premium and high
yield currencies are subordinated to the decisions of money managers, which are related
to their balance-sheet constraints, to their assessment of the conditions of financial
markets and to their level of liquidity preference. EME currencies pass through major
depreciations in times of higher liquidity preference and financial crisis at the global level,
after which they might gradually appreciate as more and more institutional investors
evaluate their prior decisions of not investing in these countries/of preferring highly liquid
assets as too conservative and decide to invest in them, resulting in a cyclical movement.

Note that emerging currencies’ dynamics are, according to these explanations,

marked by a specific type of volatility associated with extreme depreciations but not
necessarily by significant deviations every day (what is in line with empirical findings;
De Conti 2011). This type of volatility is different from that analysed by Schulmeister
(2009), depicted as zigzags, that emerge from technical trading, bandwagon and herd
behaviour. EMEs that count with deep and sophisticated FX markets might also be subject
to this type of volatility; yet, the above analyses point to an additional source of volatility
for low-liquidity currencies: one that emanates from external shocks due to their use in
international portfolio allocation and their specificities.

Although the use of the Keynesian equation contributes to synthesize and clarify
the debate about EME currencies’ demand, it cannot capture the insights brought by
Schulmeister (2009) and Harvey (2009) and is too simple for exchange rate analyses,
whose dynamics is also influenced by other economic variables. In the next section, these
insights and the specificities of EME currencies are include in the analysis of exchange
rate dynamics though the use of the ABM and SFC frameworks.

4. Consolidating the PK views through the ABM and SFC frameworks

The PK views on exchange-rates emerged from different approaches:

Schulmeister’s work is inductive, based on empirical assessments of the current workings
of FX markets; both his and Harvey’s work incorporates psychological insights; and the
discussion of the specificities of EME currencies are based on historical and institutional
analyses of the evolution of the IMFS. The following aims at suggesting ways to use the
different insights brought by these works in the ABM and SFC frameworks. This effort
contributes to the PK exchange rate literature for providing a common basis for theoretical
and empirical analysis on exchange rate determination, besides adding realism to the
treatment of exchange rates.

4.1 The advantages of the ABM and SFC frameworks for exchange rate discussion

SFC models are built from different sectors’ balance-sheets and the relation
between them, with the aim of providing a rigours description of economic relations –
without “black holes” (Godley and Lavoie 2005, 3). They are among the most prominent
type of modeling in the PK tradition (Asensio et al. 2011) and seen as “crucial to the
consolidation of the broad post-Keynesian research programme” (Macedo e Silva and
Dos Santos 2011, 105) for allowing the analysis of several of this school’s features. With
regards to exchange-rate analysis, SFC features that stand out are the consideration of
stocks and flows, monetary and productive sides of the economy, historical time and
feedback effects.

8
 SFC models clearly present the evolution of stocks, including flows and
revaluations what, with regards to exchange rate analyses, allows accurate analyses of
portfolio reallocation and countries’ vulnerabilities for considering the total amount of
capital available at a given moment for leaving the country. A model with no absence of
black holes and with all economic sectors tied together also allows analyses of contagion
among markets that are part of an investor’s network – as the importance of a fall in
returns in a market on the others.

More broadly, a complete model allows for a detailed examination of other

models’ dynamics and of the validity of their conclusions. As argued by Taylor (2009, 2)
SFC macro modeling helps to “remove many degrees of freedom from possible
configurations of patterns of payments at the macro level, making tractable the task of
constructing theories to “close” the accounts into complete models”. Therefore,
differently from literary analyses, in the SFC approach the dynamics are forced to interact
with all other variables of the economic system, requiring an explicit recognition of such
“system-wide constraints’, as well as of the potential limitations of the analyses (Dos
Santos 2006, 564). In this sense, Godley (2012) argues that SFC is an interesting
framework for allowing more detailed and precise discussions than the narrative method.

In addition, their flexibility allows for institutionally rich models (Macedo e Silva
and Dos Santos 2011) through the inclusion of not only specific country-features and
dynamics, but also the consideration of different parameters. With respect to exchange
rate dynamics, it would for instance be interesting to analyse models for developed
countries with sizeable portfolio flows, models including EMEs and considering the
consequences of their peripheral currencies, models for commodity exporters with a
height weight of the price of a good in trade flows and in agents’ expectations, among
others.

Another advantage is the possibility of considering not only the monetary side, as
in the models presented above, but also the productive one, as through the inclusion of
trade flows. This derives from the fact that in SFC models exchange rates are a “fully
interdependent system’, “part of a complete, self-contained, economic system” (Lavoie
and Daigle 2011, 244). Considering productive economy variables is key for EME
currencies’ analyses given their higher potential of facing terms-of-trade shocks, but is
also important for analyses of central currencies due to the need of considering feedback
effects such as those from the exchange rate to trade balance, domestic income, and thus
income effects on the trade balance (Lavoie and Daigle 2011) – feedbacks also ignored
in mainstream analyses of timeless equilibrium (Godley and Lavoie 2003). The
consideration of feedback effects is enabled by the treatment of time as historical – or for
its “period by period” balance sheet dynamics (Macedo e Silva and Dos Santos 2011).
Apart of feedback analyses, historical time also allows analyses of volatility and the
identification of phenomena as volatility clustering and fat tails, that are major puzzles
raised by the exchange rate literature (Lux and Marchesi 2000).

Another interesting point of the SFC framework is that its constraints can be added
to an Agent-Based model (ABM), resulting in a AB-SFC model. While most SFC models
are used to represent the macroeconomic sphere, the equations of an AB-SFC model
generaly describe the microeconomic level. For being constructed in this form, AB
models do not include any hypothesis of a single stylized behaviour for a whole
institutional sector allowing the inclusion of heterogeneous agents of decentralized

9
behaviour (Fagiolo and Roventini 2012; Fagiolo and Roventini 2016; Turrell 2016). AB
models are common in areas as physics, biology and ecology. Its application to economics
is more recent and has taken place in tandem with the growing view of the economy as a
complex system (Arthur 2013; Turrell 2016) – an understanding that is seen as a
fundamental shift in the economics profession (Colander et al, 2010; Holt et al, 2011).

The inclusion of microeconomic behaviour is interesting for exchange rate

analyses for allowing for heterogeneous agents – especially with regards to how they form
their expectations and to the magnitude of their portfolios. AB models also allow for
specific and slow changes in behaviour, in line with the argument of individual and
gradual change in liquidity preference (Author).

4.2 Exchange-rate expectations in current SFC models

As shown, PK exchange rate analyses have exchange rate expectations at their

core and are very rich in institutional details. Exchange rate modeling in PK works, on
the other hand, is very incipient and make use of important simplifications with regards
to expectations – indeed, in comparison with closed economy SFC models, there are
relatively few open-economy ones; see Caverzasi and Godin (2015). Most models use
static expectations (ee = 011; as in Godley and Lavoie 2007) what contradicts the findings
of Schulmeister (2009) on the cyclical nature of exchange rates and exchange rate
expectations. Taylor (2004) uses the uncovered interest-rate parity (UIP) to close his
model, a questionable take, in view of its large statistical failure.

Models focused on exchange rates can have a combination of traders who expect
a given exchange-rate change (ee = x), or a given exchange-rate value (Ee = x),
representing, respectively, chartist and fundamentalist traders. This configuration is
drawn from the mainstream behavioural finance literature (as De Grauwe and Grimaldi
2006). The idea of FX market participants who trade knowing the fundamental value of
the exchange rate is subject to criticisms related to the very existence of fundamental
values and of efficient market models. A fundamentalist trader might however be seen as
a participant that would knows what (part of) the other participants think about future
exchange-rate value, coherently with Orleans’s (1999) concept of an “auto-referential”
market where forecasts reflect the current financial convention. In both Lavoie and Daigle
(2011) and De Grauwe and Grimaldi (2006) the forecast is an external value (respectively
a given value and a stochastic process). In this sense, in both cases the modeling of the
exchange rate forecast through a “fundamentalist trader” does not necessarily imply the
convergence to an equilibrium exchange rate, but only that traders believe this price
exists. The simplification, in these cases, is not the assumption that there are
fundamentalist traders, but the fact that the fundamental value does not evolve with the
economy – it is static irrespective of changes in the economy or in the exchange rate itself.
Static expectations in a context of exchange-rate fluctuation are also not in line with the
representativeness principle, according to which traders would look for reasons for these
fluctuations and adapt their expectations accordingly. Possibilities of modeling an
endogenous fundamentalist behaviour are presented below.

4.3 PK insights on exchange rates through ABM and SFC frameworks

In what follows, we use the ABM and SFC frameworks to provide interesting
ways to model exchange rate expectations and portfolio allocation decisions in more

10
complex and realistic forms than in the SFC models summarized above and the current
exchange rate models described in Sections 2 and 3. These frameworks enable
considering the insights of the two strands of the PK view on exchange rates presented in
the previous sections: the impact of the different types of strategies adopted by
heterogenous agents in FX markets through expectations equations; and the influence of
the liquidity premium and the liquidity preference of global investor on EME
currencies’dynamics by detailing the portfolio allocation equations.

Starting with expectations formation, Harvey (2009) suggests that traders consider
the following variables in forming their exchange rate forecasts: trade balance, relative
output growth, and interest-rate differential (equation (3)); country $ issues a central
currency and country # issues an EME currency in all equations of this section). In an
ABM approach with heterogeneous agents their focus on each of these variables can be
varied by adjusting the parameters γ, Ω, and θ.
)
𝐸#$%&'()* = 𝐸#+,- - 𝐸#+,- [γ(𝑋# -𝐼𝑀# ) + Ω(𝑦# -𝑦$ ) + θ(𝑟# - (3)
𝑟$ )]

One could also consider an endogenous fundamentalist behaviour based on the

UIP and the PPP. The former is to say that a decrease of interest rates (𝑟# ) is expected to
)
be associated with an appreciation of the country’s currency (a decrease of 𝐸# ; 𝐸#$456 <
)
𝐸#+,- ; equation (4)). A PPP-fundamentalist trader, on the other hand, would expect
higher prices (𝑝# ) to be associated with a exchange rate depreciation (a rise of 𝐸# ;
)
𝐸#$666 > 𝐸#+,- ; equation (5)).

)
𝐸#$456 = 𝐸#+,- +(𝑟$ + 𝑟# )𝐸#+,- (4)

)
𝐸#$666 = 𝐸#+,- +(𝑝# - 𝑝$ )𝐸#+,- (5)

Both the anchoring principle, analysed by Harvey, and the medium-term

expectations, analysed by Schulmeister, have a similar effect: new forecasts depend on
past forecasts (equation (6), where 𝑥 is one of the endogenous fundamentalist rules
discussed above and 0.5 is an arbitrary value).
) )
𝐸$<=> = 0.5 𝑥 + (0.5)𝐸+,- (6)

Complex chartist behaviour can be modelled based on Schulmeister’s (2009) fast

and slow technical systems: slow chartists take into account a longer average change than
fast chartists (respectively equations (7) and (8), where 𝑚 > 𝑛).

) JKLM ,JKLN (7)

𝐸>FGHI = 𝐸+,- +
JKLN

) JKLM ,JKLQ (8)

𝐸>O&P+ = 𝐸+,- +
JKLQ

Schulmeister (2009) “contrarian” traders sell assets when their prices increase at
a declining rate, and buy when the rate at which prices decrease is dfalling. In other words:

11
if the exchange-rate change of period 𝑡 (𝑒+ ) is greater than the average observed since
period 𝑡 − 𝑛, the contrarian agent expects the future exchange rate change to be in the
opposite direction of the current trend (equation (9) for an expectation of trend reversal
after three periods of falling pace).
) (9)
𝑒+U- = −𝑒+ 𝑖𝑓 𝑒+ < 𝑒+,- < 𝑒+,Y 𝑎𝑛𝑑 𝑒 𝑖𝑠 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒,
or
𝑖𝑓 𝑒+ > 𝑒+,- > 𝑒+,Y 𝑎𝑛𝑑 𝑒 𝑖𝑠 𝑛𝑒𝑔𝑎𝑡𝑖𝑣𝑒

Harvey’s (2009) analysis of cash-in can be included through a limit in the profits
accumulated (𝐿a , in equation (10) for 𝑛 periods). In a ABM framework, its modeling
asks for a rule where an agent sell an asset when the cumulated profits achieve a given
percentage of her wealth. Although a rough approximation, this feature might be an
important inclusion given that it partly explains the reversal of a trend. Ideally, it should
be modelled for profits made with individual asset classes, what demands splitting 𝑉 a
into 𝑉$a# and 𝑉#a# for the wealth of a central country investor in its country and in the EME
country, respectively.

a 𝑉+a − 𝑉+,=
a (10)
𝐿 = a
𝑉+,=

Therefore, the suggestions above enable to model exchange rate expectations in

more complex and realistic forms, taking into account the fact that FX markets are formed
by heterogenous types of traders, adopting different strategies, as Schulmeister (2009)
and Harvey (2009) stress. Together with exchange rate expectations, the treatment of
global investors” portfolio decisions is also another area where economic models have
been excessively unrealistic, with very restrictive hypotheses. In the sequence we make
use of the flexibility of the AB-SFC framework to provide a more complex, detailed and
realistic account of these decisions through portfolio allocation equations that encompass
advanced and EME currencies and consider the influence of currencies’ liquidity
premiuns and investors’ liquidity preference in exchange rates dynamics. The suggestions
below can also be applied to analyses of two advanced currencies (whose liquidity
premium diverge) and/or assets denominated in these currencies.

The analyses of the inpact of the specificities of EME currencies is done through
changes in the portfolio allocation equations of SFC models (see Godley and Lavoie
[2007]). In these equations, total wealth (𝑉a ) of investors based in an advanced country $
is allocated among domestic (𝐵$$ ) and EMEs’ financial assets (𝐵$# )12. The demand (d)
functions for each of these assets is given by equations (11) to (14), where ri stands for
the assets' respective returns and 𝑒a) the expected exchange rate change (a positive value
denoting an expectation of appreciation of the currency i):
$ (11)
𝐵$d = 𝑉$ (λYf + λY- 𝑟$ − λYY 𝑟# + 𝑒#) )

#
𝐵$d = 𝑉$ (λgf − λg- 𝑟$ + λgY 𝑟# + 𝑒#) ) (12)

#
𝐵#d = 𝑉# (λhf + λh- 𝑟# − λhY 𝑟$ + 𝑒#) ) (13)

12
 $ (14)
𝐵#d = 𝑉# (λif − λi- 𝑟# + λiY 𝑟$ + 𝑒#) )

According to the liquidity-premium asymmetry, investors prefer investments in a

central ($), rather than in a peripheral (#) currency even if the return differential is the
$ # $
same (𝐵$d > 𝐵$d #
𝑎𝑛𝑑 𝐵#d < 𝐵#d even if 𝑟$ = 𝑟# + 𝑒#) ) due to the non-pecuniary
returns of holding a more liquid currency (Andrade and Prates 2013). This bias can be
accounted for through the definition of simple rules when defining the value of the
equations’ parameters, as the consideration that λYf > λgf 𝑎𝑛𝑑 λif > λhf . If we also want
to consider country bias (the preference for its own country’s assets) and that this is more
important than the liquidity –premium asymmetry, λif < λhf and λYf /λgf > λif /λhf .
Standard restrictions related to Tobinesque portfolio allocation parameters still hold
(Godley and Lavoie 2007; Kemp-Benedict and Godin 2017).

Appart from this structural aspect of liquidity preference, the liquidity-premium

asymmetry, a conjunctural aspect of liquidity preference is also key to exchange rate
analysis. For taking the two into consideration, the above discussed parameters 𝜆af could
Glm
be splited into a structural one, related to the liquidity-premium asymmetry, 𝜆af and a
Gl$
conjunctural one, relate to the cyclical aspect of liquidity preference, 𝜆af (equation (15)).
Gl$
The parameter 𝜆af increases in times of turbulence, leading to a shift of demand from
EME to central economy’s assets from both types of investors. Such a change in liquidity
Gl$
preference can be analysed with a SFC model through as a shock on 𝜆af , or, in an AB
model through the use of an exogenous series. In the latter case, the series could be
modelled to resemble the VIX index (the most used proxy for uncertainty and liquidity
preference in the PK literature and as risk-aversion by the mainstream): mostly stable
with eventual peaks.
Gl Glm Gl$ (15)
𝜆af = 𝜆af . 𝜆af

The Minskyan aspect that agents gradually change their decisions with the
establishment of tranquillity (Author) can be modelled in an ABM framework. The result
of this dynamic is the gradual growth of EMEs’ assets demand following the fall of
uncertainty. It could be modelled through the consideration of individual and subjective
Gl$
preference for liquid assets (𝜆+ ) that floats according to changes in a general level of
Gl$
uncertainty (𝜎+ ). Liquidity preference of investor 𝑖 at period 𝑡 (𝜆a,+ ), would be a positive
function of uncertainty in period t (𝜎+ ) and, in case of low uncertainty (𝜎+ < 𝑥), would
decrease with time – equation (16), where a higher n is given to the investor that takes
longer to react to a fall of uncertainty. This inclusion significantly improve Tobin-inspired
portfolio allocation equations used in SFC models for adding the risk feature13 and for
treating it as a personal perception, not as a measurable and single value (in line with the
PK concept of fundamental uncertainty and the behaviour economics’ concept of
framing).
,=
1 (16)
Gl$ 𝑓 , 𝜎 𝑖𝑓 𝜎+ < 𝑥
𝜆a,+ = 𝑛
+,-
𝑓 𝜎+ 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒

13
 The inclusion of equity markets is interesting given the circular dynamics it
triggers in EMEs, of asset and exchange rate appreciation and expectation of future
exchange rate appreciation, due to the magnitude of foreign investors’ assets relative to
the size of EMEs’ markets and given its increasing weight among EMEs’ foreign
liabilities (Kaltenbrunner and Painceira 2014). The modeling of equity markets is out of
the scope of this article, but its impact on portfolio equations asks for a distinction of the
return of a countries’ assets into returns from bonds and from equities, that can be
simplified to the expected change in stocks prices (𝑠𝑝s) ). This would demand adding
λag 𝑠𝑝s) + 𝑒s) to equations (11) to (14), as exemplified by equation (17).

$
𝐵$d = 𝑉$ (λYf + λY- 𝑟$ − λYY 𝑟# + 𝑒#) − λYg 𝑠𝑝) # + 𝑒#) ) (17)

5 Concluding Remarks

Exchange rates have long been a puzzle in economic literature. Post-Keynesian

analyses in this field have arisen after the breakdown of the Bretton Woods system, yet
they are rather disconnected with each other, and not broadly disseminated even in the
PK field. This article has contributed to the consolidation of the PK view on nominal
exchange rate in several manners.

On the one hand, it has critically analysed the main PK works in the field,
consolidating their arguments, their common views and limitations. The PK exchange
rate view calls attention to the role of institutional investors whose decisions are guided
by expectations and social conventions, given fundamental uncertainty and the
characteristics of Money Manager capitalism (Minsky 1986). PK works also highlight
that different currencies can have varied dynamics related to the place they occupy in the
IMFS and the balance-sheet constraints these cause to investors. As shown in sections
Two and Three, some dynamics emerge from money managers’ decisions related to their
assets’ side, others to their liabilities, others on the relationship between the two. The fact
that EMEs’ assets are part of money managers’ assets make their exchange rates subject
to changes in any market where these institutions have assets or liabilities, resulting in
long appreciation trends interrupted by sudden depreciations, subordinated to
international financial conditions.

On the other hand, the article used the ABM and SFC equations for providing a
common framework for theoretical and empirical analysis of exchange rates dynamics
coherent with the PK approach. The flexibility inherent to the AB-SFC framework allows
to consolidate the main PK works on the topic, and to enhance PK modeling, through a
more complex, detailed and realistic account of expectations formation in FX markets
and of international portfolio allocation in the current IMFS, being coherent with PK
pressupositions of realisim, historical time and the crucial role of institutions.

Notes
1
We adopt the sociological definition of mainstream economics proposed by
Dequech (2007, 281), namely, “that which is taught in the most prestigious universities
and colleges, gets published in the most prestigious journals, receives funds from the most
importante research foundations, and wins the most prestigious awards”.

14
 2
Although there are controversies on the set up of the PK approach, its
institutionalization started in the 1970s with the creation of the Cambridge Journal of
Economics and the Journal of Post Keynesian Economics (Lavoie 2014).
3
We don’t include in our acessesment the so called “cambist view” because this
view search to explain the formation of the forward exchange rate, bringing to light why
the covered interest parity relation holds very well. For more details, see Lavoie (2004).
4
Schulmeister’s economic news could also be understood as “fundamentals’,
although he doesn’t give examples. For Schulmeister (2009) the Purchase Power Parity
(PPP) defines the equilibrium value of the nominal exchange rates, although these do not
present any tendency of convergence towards this equilibrium value.
5
Orléan (1999) analyses decision making in financial markets, not specifically in
FX markets.
6
The focus on the strictly financial side is also seen in the mainstream literature.
Following the failure of models based on macroeconomic fundamentals, this literature
has turned its attention to the microstructure of FX markets (see Flood and Rose [1995]).
7
Andrade and Prates (2013) mix the post-keynesian with the structuralist
approach (i.e. Prebisch 1949; Ocampo and Martin 2003) that emphasizes the “centre-
periphery” dimension of the international economic system and its resulting asymmetries.
Paula et al. (2017) also used these two approaches to analyse the limits and challenges
for Keynesian monetary and exchange-rate policies in EMEs.
8
“(…) a power of disposal that confers a potential convenience or security”
(Andrade and Prates 2013, 402).
9
We follow herein Andrade and Prates (2013), according to whom the liquidity
premium l is determined by the position of the currency in the currency hierarchy: the
lowest this position, the smaller this premium will be. Thus, it could change only in the
medium and long term. Kaltenbrunner (2015), in turn, defines the liquidity premium as
“the ease with which the domestic currency can be used to meet future obligations plus
the expected stability of its value” (431).
10
The equation should be seen as providing the relative return of one class of
assets in the two economies.
11
The exchange rate is given as the price of the foreign currency in terms of the
domestic one.
12
Similarly, the demand of an investor based on an EME is split among
investment in its own country’s assets (𝐵## ) and assets from a central economy (𝐵#$ ).
13
Kemp-Benedict and Godin (2017) suggest a way to add risk considerations in a
Tobin model, resulting in a dynamic where risk tolerance increases in bull markets and
decreases in bear markets. This would also be the result of the modeling proposed here,
but without including the idea of individual risk perceptions.

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